Crowdfunding for real estate continues to gain momentum. As a result, certain important tax questions arise. One such question relates to dealing with state tax consequences on equity deals and whether investors are required to file income tax returns (and of course pay income tax) in the states where the real property is located or in the taxpayer’s state of residency. This can be a complex area.
Federal Tax Consequences
First, it is important to understand federal tax issues. Most real estate crowdfunding entities utilize state chartered limited liability companies (or “LLCs”) that are most likely taxed as partnerships. The LLC files a partnership tax return that includes the revenues (or income) and expenses of the entity. The partnership itself does not pay tax at the federal level. It merely passes through the profits or losses of it’s operations to the partners based on the allocation in the operating agreement. At the end of the year, the partnership will issue a K-1 to the partners to assist with their respective tax returns. This part is relatively straightforward.
State Tax Consequences
Now that we understand the federal tax issues, let’s take a look at state tax issues. These can be a bit more complex. Generally speaking, when a partnership actively conducts business activities or has “source” income in a specific state, that state will tax the individual partners. In most situations, the partners are required to file state income tax returns and pay tax on their respective share of partnership income. It does not matter what state the partners reside in. In addition, taxpayers must generally report all their income (regardless of where it was earned) in their state of residency and pay income tax.
With both states taxing the source income, it would seem to give rise to double taxation. So to avoid any double taxation issues, the state of residency will typically provide a credit for taxes paid to the other source state. The result is the taxpayer may end up paying a tax rate that is comparable to the state with the highest tax rate.
So as a general rule, the real estate crowdfunding investor may need to file a tax return in any state that the crowdfunder has real estate operations or activities. But there are some exceptions and exclusions to consider:
- When you consider the 50 states in the U.S., there are 43 that impose a state income tax. In these state you will typically be required to file, but in the 7 states with no income tax you will generally not have to file a tax return. It is important to note that some states do impose transfer taxes and other tax assessments.
- Many states do have a little known alternative to paying tax at the partner level. They will allow the partnership to file a tax return and pay tax on behalf of the partners based on what is called a composite (or “group”) filing. This tax is normally calculated at the highest state tax rate and does not provide for graduated tax rates. This is typically not a favorable option.
- Each state can have minimum filing requirements. As an example, many states will not require you to file a state return unless you have earned a certain amount of source income in the state (say for example $2,000). If the nonresident investor has earned less than this specified amount he or she would not have to file a tax return in that state.
To add another layer of complexity, many states impose withholding requirements on pass-through entities such as partnerships. So a partner who does not reside in the state in which the real estate is located may find that some of the cash distributions are being withheld by the partnership entity and remitted to the source state. Once the investor files a state tax return he will often have a portion of the withholding refunded to him. However, this withholding ensures the collection of tax at the state level.
States can differ on how the withholding is calculated and remitted. Many calculate it based on the amount of distributable income as evidenced by the state K-1 rather than the actual cash distributions made. States also can differ on when the withholding payments are made – annually or quarterly. Some states that have a withholding will not require it if the partner’s pro rata share of income is less than a set threshold amount (as an example $1,000 to $3,000).
But if you are overly concerned about filing and paying tax in many states, there are a couple points to consider. As a result of depreciation expense, the partnership’s taxable income will often be lower than cash distributions you will be receiving. You may find that your K-1 even reflects a loss. So many real estate crowdfunding investors may realize that they are not paying taxes to a source state and conceivably not required to file a state tax return (aside from reflecting a net operating loss carryforward).
So if you invest in a crowdfunding real estate syndication, how do you know if you are subject to taxes or withholding in a given state? The answer is not as tough as you may have thought. A state specific K-1 will be issued to the partners which will reflect their applicable share of state sourced income and withholding. But make sure that you engage a CPA or other tax professional who understands state specific tax issues for partnerships.
Understanding state tax issues relating to real estate crowdfunding can be tough. As an investor, please ensure that you do your own due diligence and consult with an experienced CPA or tax professional to ensure that your state income tax filings are accurate and complete.